Emerging Market Stocks: Bargain or Value Trap?

I was recently lectured on Twitter by a Wall Street strategist about why emerging market stocks (NYSEARCA:EEM) are a raging buy. Among his top arguments for being and staying long were extremely negative sentiment and chart patterns. He was particularly adamant about “depressed values” in Chinese stocks.

Interestingly, the view among other strategists that emerging market stocks are trading at bargain basement prices is so common on Wall Street, you could throw a penny in any direction and hit the right analyst.

“China has a lot of tailwinds over the balance of the year” Eric Brock, at Clough Capital Partners, 9/27/13

The problem with these views – besides the fact they’re all dead wrong – is they ignore reality. Common sense tells us that what’s happening on the streets of Bangkok (NYSEARCA:THD) or Beijing always trumps an overdue technical bounce or cheap market valuation. Are riots bullish? How about urban air pollution that’s 10 times higher than the World Health Organization’s recommended levels? And you know what trumps that? The real time price action of stocks, which in turn, determines the winners and losers.

History Lesson on “Cheap”Six years ago, we got an ugly lesson in what cheap financial assets smell like. Bear Stearns and Lehman Brothers – just before they went extinct – were both undervalued. Both companies were also way overdue for a technical bounce, according to leading chart readers of the day. Even CNBC’s Jim Cramer, who according to some accounts, eats and sleeps ticker symbols, was thoroughly tricked.

On March 11, 2008, Cramer yelled at a national audience saying, “Bearn Stearns is not in trouble” right when the stock was at $62.97 per share. Less than a week later, JP Morgan Chase acquired Bear for a renegotiated fire sale price $10 per share.

And so it is: During a crisis, as many emerging markets find themselves in today (see Argentina, Brazil, Turkey, and Thailand) cheap valuations can get cheaper. And buying too early is the wrong strategy because the road to destruction is littered with carcasses that paid attention to every piece of financial data they could consume, but the irrevocable truth of price action. Buying the right assets at the wrong prices is good for your ego, but not for your wallet.

Fast Forward to NowIn just a matter of two months, Shanghai’s Composite Stock Index (Shanghai: 000001.SS) has already fallen almost 9% and has surpassed 2013’s entire annual decline of 6.75%.

Rather than buying into the propaganda du jour that emerging market stocks (NYSEARCA:EDZ) are cheap and overdue for a technical bounce, via our Weekly ETF Picks from Dec. 5, 2013 we took a stark opposite opinion of Wall Street’s populist view by writing:

“While we respect the rally Chinese stocks have enjoyed (7/3/13 to 12/1/13 run) , we’re nonetheless suspicious about the sustainability of the run. Aside from huge systematic risks, the Federal Reserve’s eventual scale back of QE is a threat to rising asset prices. We’re buying ProShares UltraShort FTSE China ETF (NYSEARCA:FXP) at $14.65.”

With Asia celebrating the Lunar New Year, China’s leadership will have time during the fiesta to come up with more Band-Aid solutions to repair their mortal economic wounds. Curtailing excessive credit expansion without curtailing economic growth is like trying to achieve a slim physical build on a cheesecake diet. Besides that, the People’s Bank of China hasn’t had much experience with this kind of crisis stuff, as their infrequent and devilishly opaque press releases show.

One of the few things Chinese equity bulls can celebrate is that Shanghai’s Stock Market will be officially closed through Feb. 7.

The ETF Profit Strategy Newsletter uses technical, fundamental, and sentiment analysis along with market history and common sense to keep investors on the right side of the market. In 2013, 70% of our timestamped weekly ETF picks were profitable and a 525% gain was our biggest winner.

2 comments on “Emerging Market Stocks: Bargain or Value Trap?”

According to Jim Oneill, ex CEO at goldman, he is laughing at all of the china negativity. Being a longer term investor, Buffet says to “be greedy when others are fearful…”
I myself trade buy-side for 20 years, and knowing that markets generally go up over time, I am very long selective emerging markets, including China. Being short may give you a temporary bounce, but try staying short for 5 years and get back to me. I rarely play short, and prefer toggling back and forth between safer and more aggressive assets. Just like 2008, markets bounce back 90% of the time, and those are great odds. Add in positive demographics, population growth, average population age,VALUATION and China looks like a fantastic opportunity, even if it goes down 15% first. That what dollar cost averaging is for…

A strategic short trade won’t typically last 5 yrs because shorting isn’t a buy-and-hold strategy. Comparing the two techniques is apples and oranges.

China’s developing credit is still in its earliest stages and not even close to being over.

I think you’re right-on that emerging markets will become a good investment from a longer term buy-and-hold angle. But if we can buy EM’s at even lower prices – the prudent course is to patiently wait for capitulation vs. jumping the gun.

P.S. We exited the final leg of our FXP trade for a timestamped 2-month gain of 23.5%. Our original buy alert on FXP was on 12/6/13, look at the chart. Markets fall faster than they rise and FXP may offer us another shot in the future, we’ll see.